The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, April 11, 2012

In an Irish Times column, the author discusses how the IMF committed Ireland to the Japanese model for handling a bank solvency led financial crisis and its on-going permanent economic decline and now the IMF endorses the Swedish model and its rapid economic recovery.

“BOLD” HOUSEHOLD debt-restructuring programmes can help prevent recessions becoming deeper and more protracted, according to research by the International Monetary Fund....

The study said restructuring household debt “can significantly reduce debt repayment burdens and the number of household defaults and foreclosures.

Such policies can therefore help avert self-reinforcing cycles of household defaults, further house price declines, and additional contractions in output.”

In short, if you adopt the Japanese model and don't restructure the existing debt to what the borrowers can afford to pay, then the real economy faces a hurdle to growth it cannot overcome.

In a chapter of the World Economic Outlook report entitled “Dealing with household debt”, the IMF economists find that recessions preceded by periods in which households have run up large debts tend to last “at least five years”.

In the case of Japan, we are talking 2+ decades.

The Irish economy began contracting four years ago....

In the case of Japan, the adoption of the Japanese model and not restructuring the debts has led to 2+ decades of recession (its GNP was actually lower in 2010 than 1995).

A number of the case studies cited in the paper may have relevance for the Irish situation....

Case studies that examine what happens when the Swedish model is adopted and debt is restructure based on the borrowers' capacity to pay.

The IMF had a significant input into the design of [the debt restructuring] mechanisms as it was the main source of funding to the north Atlantic state when it was unable to borrow after the collapse of its banking system in 2008.

Specifically, at the urging of the creditor states in the EU, it pushed for the Japanese model of only recognizing losses to the extent that the banks generate earnings in excess of banker bonuses, dividends and modest book capital increases.

The report notes that the case-by-case approach in Iceland to writing off debts of households which had little or no chance of repaying them proceeded slowly....

The Irish banks are not making much money before loss recognition so they have little ability to absorb losses through their current income stream.

The study concludes that a comprehensive framework and an explicit timeframe are necessary for restructuring programmes to be effective.

This is how the Swedish model works. The banks are told to recognize the losses on the portion of the debt that the borrowers cannot afford to pay today. The banks then subsequently retain future earnings to restore their book capital levels.

Given that the authors’ colleagues are involved in overseeing Ireland’s EU-IMF bailout, the strong endorsement of writing down debts may increase speculation that bigger, Iceland-style restructurings could take place here in the future.

Without these restructurings, Ireland's real economy is condemned to a long term recessionary environment.

Separately, and mirroring the situation in Ireland, the report finds that “strong capital buffers may be insufficient to encourage banks to restructure household debt on a large scale, as is evident in the US today”.

In fact, under the Japanese model using bank capital to absorb losses is explicitly forbidden. Losses are only taken as earnings are recognized.

Fundamental to the Japanese model is the idea that depositors equate a healthy bank to a bank with positive book capital levels. In reality, government deposit guarantees mean that depositors don't care about a bank's capital level and in most cases do not even know what it is.

Fundamental to the Japanse model is the idea that banks only make loans when they have positive book capital levels. The US Savings and Loan crisis showed this isn't true as these financial firms knew they had negative book capital levels, they were only positive due to a government sanctioned accounting gimmick, and they continued to make loans.

The report acknowledges that government-supported restructuring schemes do involve one group in society effectively subsidising those who benefit from the scheme, but the case for doing so depends on the net cost/benefit for the economy as a whole.

This is true and is the reason that I proposed that Wall Street rescues Main Street. It seems perfectly reasonable that that after making money leveraging up Main Street during the years leading up to the financial crisis, that Wall Street should not subsidize Main Street in restructuring the excess debt.

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